One of the financial advisors’ primary responsibilities is to determine and document their clients’ target asset allocation. The target allocation serves as a starting point and guideline in diversifying the client portfolio and building future wealth. Clients’ unique financial goals, lifestyle, investment horizon, current and expected income and emotional tolerance to market turbulence will impact their future asset allocation.
The target investment mix is not constant. It can shift from more aggressive to more conservative or vice versa with substantial changes in lifestyle, family status, personal wealth, employment, and age.
Assess your risk tolerance
Most advisors use questionnaires to evaluate their client’s risk tolerance. The length of these surveys varies from advisor to advisor. Furthermore, some assessments are available online for free. The idea behind all of them is to determine the investor’s tolerance to market volatility, and unpredictable macroeconomic and life events.
Individuals with high-risk tolerance have the emotional capacity to take on more risk. They can endure significant market swings in order to achieve a higher future return.
On the opposite side, investors with low-risk tolerance are willing to sacrifice higher returns for safer, low volatility assets which will have smaller swings during turbulent markets.
A free risk tolerance test is available here:
Regardless of which test you take, if you answer all questions consistently, you should expect to get similar results.
Advisors, of course, should not rely solely on test results. They need to know and understand their clients. Advisors must have a holistic view of all aspects of client’s life and investment portfolio.
Set your financial goals
Your financial goals are another critical input to determine your target investment mix. Your goals can stretch anywhere from a couple of months to several decades. They can be anything from paying off your debt, buying a house, planning for a college fund, saving for a wedding, a trip or retirement, making a large charitable donation and so on.
Each one of your goals will require a different amount of money for completion.
Having your goals in place will define how much money you need to save in order to reach them. The range of your goals versus your current wealth and saving habits will determine your target asset allocation.
More aggressive goals will require more aggressive investment mix.
More balanced goals will call for more balanced investment portfolio.
Sometimes, investors can have a conflict between their financial goals and risk tolerance. An investor may have low to moderate risk tolerance but very aggressive financial goals. Such conflict will ultimately require certain sacrifices – either revising down the investor’s financial goals or adjusting his or her willingness to take on more risk.
Define your investment horizon
Your investment horizon and the time remaining to your next milestone will significantly impact your investment mix.
529 college fund plan is an excellent example of how the investment horizon changes the future asset mix. Traditional 529 plans offer age-based investment allocation. The fund is initially invested in a higher percentage of equity securities. This original investment relies on the equities’ higher expected return, which can potentially bring higher growth to the portfolio. Over time, as the primary beneficiary (the future student), approaches the first year in college, the money in the 529 plan will gradually be re-allocated to a broadly diversified portfolio with a large allocation to fixed income investments. The new target mix can provide more safety and predictable returns as the completion of the goal approaches.
The same example can apply for retirement and home purchase savings or any other time-sensitive goal. The further away in time is your goal; the stronger will be your ability to take on more risk. You will also have enough time to recover your losses in case of market turmoil. In that case, your portfolio will focus on capital growth.
As the completion time of your goal approaches, your affinity to risk will decrease substantially. You also won’t have enough time to recover your losses if the market goes down considerably. In this situation, you will need a broadly diversified portfolio with refocusing on capital preservation.
Know your tax bracket
The investors’ tax bracket is sometimes a secondary but often crucial factor in determining asset allocation. The US Federal tax rate ranges from 10% to 39.6% depending on income level and filing status. In addition to Federal taxes, individuals may have to pay state and city taxes.
Investors can aim to build a tax-efficient asset allocation. They can take advantage of preferential tax treatment of different financial securities among various investment account types – taxable, tax-deferred and tax-exempt accounts.
For instance, they may want to allocate tax efficient investments like Municipal bonds, MLPs, ETFs and Index funds to taxable accounts and higher tax bearing investments like Gold, Bonds, and REITs into tax-advantaged accounts.
In any case, investors should attempt to achieve the highest possible return on an after-tax basis. Building a tax-efficient investment portfolio can add up to 1% or more in performance over an extended period.
About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.